Ieq Dec13 English

December 2013

Slower growth; high risks

Supported by funding from the Australian Government (Department of Foreign Aairs and Trade, DFAT), under the Support for Enhanced Macroeconomic and Fiscal Policy Analysis (SEMEFPA) program.

INDONESIA ECONOMIC QUARTERLY Slower growth; high risks

December 2013

Preface

The Indonesia Economic Quarterly (IEQ) has two main aims. First, it reports on the key developments over the past three months in Indonesias economy, and places these in a longer-term and global context. Based on these developments, and on policy changes over the period, the IEQ regularly updates the outlook for Indonesias economy and social welfare. Second, the IEQ provides a more in-depth examination of selected economic and policy issues, and analysis of Indonesias medium-term development challenges. It is intended for a wide audience, including policymakers, business leaders, financial market participants, and the community of analysts and professionals engaged in Indonesias evolving economy.

The IEQ is a product of the World Banks Jakarta office. The report is compiled by the Macro and Fiscal Policy Cluster, Poverty Reduction and Economic Management (PREM) Network, under the guidance of Jim Brumby, Sector Manager and Lead Economist, Ndiame Diop, Lead Economist and Economic Advisor, and Ashley Taylor, Senior Economist. Led by Alex Sienaert, the core project team, with responsibility for Part A (economic update), editing and production, comprises Arsianti, Magda Adriani, Brendan Coates, Fitria Fitrani, Ahya Ihsan, Elitza Mileva, Violeta Vulovic and Michele Savini Zangrandi. Administrative support is provided by Titi Ananto and Sylvia Njotomihardjo. Dissemination is organized by Farhana Asnap, Indra Irnawan, Jerry Kurniawan, Nugroho Sunjoyo, Randy Salim and Marcellinus Winata, under the guidance of Dini Sari Djalal.

This edition of the IEQ also includes contributions from Leni Dharmawan, Lily Hoo, Mattia Makovec, Arvind Nair, Cindy Paladines, Della Temenggung, Violeta Vulovic, and Matthew Wai-Poi. Key input was received from The Fei Ming, Neni Lestari, Djauhari Sitorus, Connor Spreng, Ekaterine Vashakmadze and Anna Wetterberg. The report also benefited from discussions with, and in-depth comments, from Mark Ahern, Jamie Carter, Sjamsu Rahardja, David Nellor and Bill Wallace (Australia Indonesia Partnership for Economic Governance) and Roland Rajah (Department of Foreign Affairs and Trade).

This report is a product of the staff of the International Bank for Reconstruction and Development / The World Bank, supported by funding from the Australian Government under the Support for Enhanced Macroeconomic and Fiscal Policy Analysis (SEMEFPA) program. The findings, interpretations, and conclusions expressed in this report do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent, or the Australian Government. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Cover and chapter photographs are taken by Josh Estey and Ed Wray and are copyright of the World Bank. All rights reserved.

For more World Bank analysis of Indonesias economy: For information about the World Bank and its activities in Indonesia, please visit

www.worldbank.org/id. In order to be included on an email distribution list for this Quarterly series and related publications, please contact [email protected]. For questions and comments relating to this publication, please contact [email protected].

Table of contents

EXECUTIVE SUMMARY: SLOWER GROWTH; HIGH RISKS .......................................... I

A. ECONOMIC AND FISCAL UPDATE ............................................................................... 1 Slowly improving global demand, external financing risks remain ............................................................. 11. Despite strong consumption, Indonesias economic growth is slowing ...................................................... 32. Headline inflation has normalized but core inflation is rising ..................................................................... 63. Indonesias current account deficit remains in focus, despite slowing imports .......................................... 94. Credit conditions are expected to tighten further moving into 2014 .......................................................... 145. Public expenditure and tax revenue growth has slowed over 2013 ............................................................. 176. Given prevailing risks, further progress on pro-growth reforms is needed ................................................ 207.

B. SOME RECENT DEVELOPMENTS IN INDONESIAS ECONOMY ........................ 231. A closer look at the 2014 Budget .................................................................................................................. 232. An update on poverty in Indonesia ............................................................................................................. 28

C. INDONESIA 2015 AND BEYOND: A SELECTIVE LOOK ........................................... 321. The labor market in Indonesia: recent achievements and challenges ....................................................... 32

a. The challenges of an ongoing but incomplete structural transformation .......................................................... 35b. Good jobs rising, but many workers remain informal and vulnerable ............................................................ 36c. Coping with a largely unskilled labor force ......................................................................................................... 37

2. Local capacity and development in Indonesia ............................................................................................ 38

a. A brief history of community-driven development in Indonesia ........................................................................ 38b. Understanding changes in local capacity since 2001 .......................................................................................... 39c. Democratization, decentralization, CDD and local capacity ........................................................................... 41d. and the importance of enhanced checks and balances at the village level ..................................................... 42

APPENDIX: A SNAPSHOT OF INDONESIAN ECONOMIC INDICATORS ................ 43

LIST OF FIGURES

Figure 1: Key commodity export prices show signs of stabilizing at broadly flat levels compared with a year ago ............................................................................................................. 2

Figure 2: Global and emerging market sovereign debt funding costs remain on an up-trend ........ 2Figure 3: Real GDP growth is moderating, falling to 5.6 percent yoy and 5.0 qoq saar in Q3 .... 3Figure 4: though nominal GDP growth increased sharply in Q3 on the back of rising economy-

wide prices ................................................................................................................... 3Figure 5: Investment growth has slowed markedly while consumption growth has remained

strong ........................................................................................................................ 4Figure 6: with only building investment driving overall positive investment growth .................. 4Figure 7: High frequency indicators are mixed but are below their previous highs ........................ 5Figure 8: The prices of some key foods are stabilizing after a volatile year ..................................... 7Figure 9: Seasonal food deflation and fading transport price rises have pushed down headline

monthly CPI inflation .............................................................................................. 8Figure 10: but core inflation momentum has increased notably ................................................... 8Figure 11: The current account deficit stabilized at USD 8.4 billion in Q3 ................................ 10Figure 12: helped by the non-oil-and-gas trade balance returning to surplus since August ...... 10Figure 13: The weakness in overall imports has been led by a contraction in capital goods ........ 10Figure 14: Manufacturing and construction together absorb almost 70 percent of Indonesias

imports ....................................................................................................................... 10Figure 15: Weaker portfolio investment led to a lower capital and financial account surplus in Q3

relative to Q2 .......................................................................................................... 12Figure 16:but measures of onshore FX spot market liquidity conditions have improved since

mid-year ..................................................................................................................... 14Figure 17: Bank credit growth has been inflated by exchange rate effects................................. 16Figure 18: but has slowed, particularly in real terms ............................................................... 16Figure 19: Rupiah liquidity has tightened and interbank borrowing costs have risen ................... 16Figure 20: The 2014 Budget targets a smaller deficit than in 2013 and further reduction in the

ratio of debt-to-GDP .............................................................................................. 24Figure 21: but despite this, gross fiscal financing requirements are likely to be similar to 2013s

high levels .................................................................................................................. 24Figure 22: Energy subsidies still consume a significant part of the Budget .................................. 25Figure 23: The pace of poverty reduction in recent years has been the slowest in over a decade . 28Figure 24: The remaining poor households in Indonesia are further below the poverty line than

earlier in the 2000s .................................................................................................. 28Figure 25: while the poor and vulnerable also participate less in Indonesias recent economic

growth ........................................................................................................................ 28Figure 26: Of Indonesias labor force of 121 million workers, 114 million are employed (less than

half in the formal sector) ............................................................................................ 33Figure 27: The rise in the employment rate in Indonesia since 2005 has been among the

strongest in the region ............................................................................................... 33Figure 28: Year-on-year employment growth has been sustained since 2005, although slowing

down after 2011 ........................................................................................................... 34Figure 29: Formal employment contributed four-fifths total job creation between 2001 and 2012 34Figure 30: Low value-added sectors in services have contributed mostly to job creation between

2001 and 2012 .............................................................................................................. 35Figure 31: Employment growth and labor productivity growth are negatively correlated ............. 35Figure 32: Important wage differences exist between sectors, and within sectors between type of

employment ............................................................................................................... 36Figure 33: Dependent employment is on the rise, but most workers are still employed in

vulnerable forms of work ........................................................................................... 36

Figure 34: Although the labor force has become more skilled, less than 8 percent has a university degree ......................................................................................................................... 37

Figure 35: Over 40 percent of Indonesias youth aged 15-24 are not in employment, education or training ....................................................................................................................... 37

LIST OF APPENDIX FIGURES

Appendix Figure 1: Quarterly and annual GDP growth.................................................................. 43Appendix Figure 2: GDP expenditure contributions ...................................................................... 43Appendix Figure 3: Contributions to GDP production ................................................................... 43Appendix Figure 4: Motor cycle and vehicle sales .......................................................................... 43Appendix Figure 5: Consumer indicators........................................................................................ 43Appendix Figure 6: Industrial production indicators ..................................................................... 43Appendix Figure 7: Real trade flows ............................................................................................... 44Appendix Figure 8: Balance of payments ........................................................................................ 44Appendix Figure 9: Exports of goods .............................................................................................. 44Appendix Figure 10: Imports of goods ............................................................................................ 44Appendix Figure 11: Reserve and capital inflows ............................................................................ 44Appendix Figure 12: Inflation and monetary policy ........................................................................ 44Appendix Figure 13: Monthly breakdown of CPI ........................................................................... 45Appendix Figure 14: Inflation across countries ............................................................................... 45Appendix Figure 15: Domestic and international rice prices .......................................................... 45Appendix Figure 16: Poverty and unemployment rate .................................................................... 45Appendix Figure 17: Regional equity indices .................................................................................. 45Appendix Figure 18: Dollar index and Rupiah exchange rate ........................................................ 45Appendix Figure 19: 5-year domestic govt. bond yields ................................................................. 46Appendix Figure 20: Sovereign USD Bond spreads ........................................................................ 46Appendix Figure 21: International commercial bank lending ........................................................ 46Appendix Figure 22: Banking sector indicators .............................................................................. 46Appendix Figure 23: Government debt ........................................................................................... 46Appendix Figure 24: External debt .................................................................................................. 46

LIST OF TABLES

Table 1: Indonesias economic growth rate is projected to slow to 5.3 percent in 2014 ................. iiiTable 2: Under the baseline scenario GDP growth of 5.6 percent is projected for 2013 and 5.3

percent for 2014 ............................................................................................................ 6Table 3: The persistence of a current account deficit is likely to keep the need to support FDI in

focus ........................................................................................................................... 12Table 4: External debt repayments in Q4 2013 have been high, likely adding to Rupiah

pressures ................................................................................................................. 12Table 5: Higher Budget disbursement characterized the Jan Nov 2013 period, relative to

previous years ............................................................................................................. 18Table 6: The World Bank projects a fiscal deficit of 2.1 percent of GDP in 2014, narrowing from

2.5 percent in 2013 ...................................................................................................... 19Table 7: Modestly weaker than expected consumption and investment growth could move 2014

GDP growth down to below 5 percent ...................................................................... 20Table 8: The approved fiscal deficit in 2014 is 1.7 percent of GDP, slightly higher than previously

proposed ..................................................................................................................... 26Table 9: Macroeconomic and price assumptions have been revised in a conservative direction

from those in the August proposal ............................................................................ 27

Table 10: The Medium-Term Budget Framework projects an overall surplus by 2016 ................. 27Table 11: Comparison of Key Research Aspects in LLI1, LLI2, and LLI3 ..................................... 40

LIST OF APPENDIX TABLES

Appendix Table 1: Budget outcomes and projections .................................................................... 47Appendix Table 2: Balance of Payments ......................................................................................... 47Appendix Table 3: Indonesias historical macro-economic indicators at a glance ....................... 48Appendix Table 4: Indonesias development indicators at a glance .............................................. 49

LIST OF BOXES

Box 1: The potential near-term impact of the proposed ban on unprocessed mineral exports on Indonesias trade balance .......................................................................................... 13

Box 2: Update on the policies to improve the investment climate in Indonesia ............................ 22Box 3: BLSM, Susenas and measuring poverty ............................................................................... 29Box 4: Local Level Institutions Studies methodology .................................................................... 40

S l o w e r g r o w t h ; h i g h r i s k s I n d o n e s i a E c o n o m i c Q u a r t e r l y

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December 2013 THE WORLD BANK | BANK DUNIA

Executive summary: Slower growth; high risks

Looking ahead to 2014, Indonesia faces slower growth, and significant economic risks

The final quarter of 2013 has seen the continuing adjustment of the Indonesian economy to more subdued commodity prices and tighter external financing conditions, and to the related pressures on external balances. Policies have responded, particularly through tighter monetary conditions, the Rupiah has depreciated substantially in real terms, and investment spending and output growth have weakened. These developments are broadly supportive of continued macroeconomic stability, including by helping to lower the current account deficit, although their impact continues to play out, adding additional uncertainty to the path of the domestic economy. At the same time, the international environment is also shifting, with global growth expected to improve, bringing potential policy changes, notably in US monetary policy, which could add to the pressures on Indonesias external financing position.

requiring a policy focus not only on macro adjustment but also on credible implementation of longer-term investment- and export-enhancing reforms

In light of the slower pace of growth, and the risks facing the economy, there is a strong need for Indonesia to augment the recent macro focus on tighter monetary policy, exchange rate adjustment and import compression, with deeper reforms to lift export performance and support investment inflows, especially FDI. Progress on the credible implementation of such measures can help to limit the vulnerability of Indonesias external balances to tighter, or more volatile, global financing conditions and can help to support a sustainable virtuous cycle of strong investment, including foreign investment, and output growth over the medium term. The political dynamics of an election year may play an important role in framing policy choices in 2014 but this backdrop also adds importance to the need for clear communication and coordination of such deeper reforms, both in the formulation and implementation stages, and for the avoidance of policy missteps. This would support local and foreign investor confidence in Indonesias future economic trajectory, and external financing inflows.


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The performance of the global economy is expected to improve further in 2014

Economic conditions amongst the worlds largest economies, and Indonesias major trading partners, remain uneven. Growth in the US has picked up steam over 2013, the Euro Area has finally exited its long recession but its recovery remains subdued, while growth in Japan, though positive, has weakened. Chinas economic activity accelerated in the second half of 2013, joined in recent months by India, but activity in some other major developing economies like Brazil has remained more subdued. Moving into 2014, the baseline expectation is for global economic conditions to strengthen, as high income economies gain more traction, supporting growth in developing economies, notably including China, and resulting in a continued modest expansion in the demand for Indonesias exports.

and commodity prices have stabilized

International commodity prices have generally increased in recent months lifting the price index of Indonesias top ten commodity exports by 3.8 percent since August (though it remains 2 percent lower in 2013 and 22 percent below its recent peak in February 2011), helped by higher coal, natural gas, and palm oil prices. If sustained, the nascent stabilization in commodity prices would help arrest the decline in Indonesias terms of trade which has driven much of the deterioration in the external balances. However, the baseline outlook of only a moderate pick-up in global growth, coupled with the likelihood of tightening global liquidity conditions and more structural downward pressure on prices from supply-side factors, does not suggest a major upswing in commodity prices in 2014.

but international policy risks and financial conditions continue to pose challenges for Indonesia

The international outlook, although improving, still contains sizeable policy challenges and uncertainties. In Europe, the recovery is fragile and will likely be uneven due to ongoing deleveraging and considerable reform challenges. In Asia, the pace and manner in which ambitious structural reform efforts in China and Japan are implemented, and elections in India, will shape the outlook. Above all, the timing and pace of the phasing out of the US Federal Reserves asset purchase program (so-called tapering) is uncertain, but keeps the risks of global market volatility and more difficult external financing conditions to the fore.

Domestic policy and economic adjustments over 2013 have been significant

As highlighted in the October 2013 IEQ, the expectations of tapering, and related tighteningexternal financing conditions, beginning in May, combined with the gradual transmission of lower commodity prices since 2011, have precipitated a number of important economic and policy adjustments in Indonesia over the second half of 2013, which are ongoing. Bank Indonesia (BI) has raised its policy interest rate corridor by 175 basis points (bp) since June, when the Government increased subsidized fuel prices by an average of 33 percent. The Rupiah has depreciated by 24 percent against the US Dollar year-to-date, largely since August, and in real trade-weighted terms fell by 12.5 percent from its recent peak in May through October.

and growth has slowed notably, reducing import demand, especially of capital goods, helping to stabilize the current account deficit

Indonesias economic growth has slowed notably, to 5.6 percent year-on-year (yoy) in the third quarter, marking the fifth consecutive quarter of declining growth from the recent high of 6.4 percent yoy in Q2 2012. Most of the slowdown has been driven by softening investment spending, which was up a relatively modest 4.5 percent yoy in the third quarter, reflecting contractions in machinery and equipment investment from their year-ago levels. Weaker investment spending has cut capital goods imports, the US Dollar value of which was 16.3 percent lower yoy over the three months to October. Overall import volumes have been subdued, and contracted significantly in Q3. Export volumes also contracted in sequential terms in Q3, but not by as much as imports, such that net exports added significantly to output growth. Overall, indications are that Indonesias trade balance is shifting in such a way as to stabilize and begin to narrow the overall current account deficit.

Macroeconomic adjustments to date have been broadly positive for stability, but do carry some costs

The monetary policy and exchange rate adjustments seen in 2013 are broadly positive for macroeconomic stability, with the depreciation of the Rupiah acting as a shock absorber for the weaker terms of trade by supporting export earnings and dampening import demand. However, these adjustments carry costs, and can bring potential risks, notably by placing pressure on public and private sector balance sheets by raising the Rupiah value of external debtparticularly if there are currency mismatchesand eroding incomes through higher debt servicing and import costs.


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and while the 2014 Budget maintains a prudent stance it does not contain any major fiscal reforms

The above monetary policy and exchange rate changes are carrying the burden for near-term macro adjustment. On the fiscal side, the 2014 Budget, approved by Parliament on October 25, maintains a non-expansionary stance, projecting a smaller overall fiscal deficit of 1.7 percent of GDP. However, the Budget does not include any major revenue or expenditure reforms, though it does incorporate a reduction in the allocation to electricity subsidies by 29percent relative to 2013, reflecting the intention for ongoing upward tariff adjustment. With the impact of the June 2013 price hike offset by the weakness in the Rupiah, the budget allocation to fuel subsidies is set to remain significant in 2014 at IDR 211 trillion (or 2.0 percent of GDP), up IDR 11 trillion on the 2013 revised Budget level.

The World Bank projects GDP growth to slow to 5.3 percent in 2014, and the current account deficit to narrow

As the impact of less buoyant commodity prices, tighter external financing conditions, higher real domestic interest rates, and the depreciation of the Rupiah, continues to play out, Indonesias GDP growth is projected by the World Bank to slow to 5.3 percent yoy in 2014 in the base case (Table 1), from 5.6 percent in 2013. Helped by relatively subdued import growth and a mild pick up in exports, the current account deficit should narrow, to USD 23 billion in 2014 (2.6 percent of GDP), from USD 31 billion (3.5 percent of GDP) in 2013. Table 1: Indonesias economic growth rate is projected to slow to 5.3 percent in 2014

2011 2012 2013p 2014p Real GDP (Annual percent change) 6.5 6.2 5.6 5.3 Consumer price index (Annual percent change) 5.4 4.3 7.0 6.1 Current account deficit (Percent of GDP) 0.2 -2.8 -3.5 -2.6 Budget balance (Percent of GDP) -1.1 -1.9 -2.5 -2.1 Major trading partner GDP (Annual percent change) 3.6 3.4 3.4 3.9

Source: BI; BPS; Ministry of Finance; World Bank staff projections (2013p and 2014p)

but risks around this base line are skewed towards slower growth

These projections, however, are subject to significant uncertainty, and risks are tilted towards weaker domestic growth. In particular, the baseline view is contingent on external financing conditions being sufficiently supportive to avoid precipitating a more abrupt external balance adjustment, causing economic disruption and a knock-on impact on growth. Such a deterioration could be triggered by international market developments, or be specifically due to domestic economic and policy developments. In addition to the risks around growth, there are also risks to the fiscal outlook. For example, the World Bank estimates that a 10 percent depreciation of the Rupiah increases the fiscal deficit by 0.3-0.4 percentage points of GDP, largely by raising fuel subsidy costs (see the October 2013 IEQ).

with a particular focus on risks to investment growth, but also to the resilience of private consumption

Indonesias GDP forecasts are particularly sensitive to the investment outlook which faces risks from further real interest rate increases and exchange rate volatility, or from a greater-than-expected tightening in credit conditions impacting the thus-far solid growth in building investment. There is also the risk that private consumption growthalthough notably resilient to datemay come under more pressure from higher prices and interest rates, weaker income growth and negative wealth and confidence effects. Even mildly weaker domestic demand growth than currently anticipated (e.g. a 0.5 percentage points reduction in private consumption and investment growth relative to their base lines) could reduce 2014 growth to below 5 percent. A more severe moderation in domestic demand, for example, due to an intensification of external financing constraints or negative confidence effects associated with policy missteps, could feasibly move 2014 growth to below 4.5 percent.

There is a need for policies to support exports and FDI inflows, and to avoid potentially damaging measures aimed at import suppression

With consumption goods accounting for less than 10 percent of Indonesias imports, the slowdown in imports, while supporting a reduction in the current account deficit, mainly means less raw material and intermediate products for manufactured goods production, and fewer capital goods. In the absence of available, competitive, domestic substitutes this will likely come at a direct cost to current and future export and output growth. While import compression due to relative price and income effects can play a useful short-term role in the adjustment process, the real policy challenge for Indonesia is therefore not to focus on additional import suppression through regulatory measures, but rather to increase exports, and to secure more and higher quality external financing, particularly FDI.


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Measures to support improvements in the business environment have an important role to enhance Indonesias underlying attractiveness to FDI inflows

While FDI into Indonesia has so far proved resilient, if still at lower levels relative to GDP than many regional peers, it is underpinned by three factors which have all come under varying degrees of recent pressure: Indonesias huge natural resource base (undercut by generally softer global commodity prices and regulatory uncertainties), the large and growing domestic market (undercut, at least in the near-term, by the headwinds facing domestic demand), and Indonesias potential as a regional production hub in Asia (undercut by regulatory uncertainties, and skills and infrastructure gaps). Consequently, there is a clear need to make more progress to support FDI, including by moving forward on a pro-investment revision of the negative investment list (DNI), a centerpiece of the Governments August policy package still awaiting implementation, and strengthening the quality of the overall investment policy formation process to minimize policy uncertainty. The Government has also launched a significant policy package to improve the ease of doing business, with an action plan announced on October 25 across eight Doing Business areas. The challenge now is to implement this package on the ambitious February 2014 timeline, providing a positive signal as to the trajectory of the business environment and commitment to reform implementation.

and process and regulatory improvements in trade facilitation and logistics could also deliver quick wins to lift exports

The real depreciation of the Rupiah over 2013, by boosting international competitiveness, presents an opportunity for Indonesia to improve its export performance. Furthermore, the weakening in commodity prices could also shift investment more towards the non-resources sector, including export-oriented manufacturing. As highlighted in the October 2013 IEQ, a number of quick wins are available in trade facilitation and logistics, focusing on the performance of import cargo clearance in ports such as Tanjung Priok in Jakarta, which by improving efficiency and predictability in trade logistics could boost exports and strengthen Indonesias participation in the global production network. Supporting longer-term export competitiveness also requires a continued focus on plugging infrastructure and skills gaps.

A continued emphasis on the quality of spending, including, through subsidy reform, can help to meet longer-term development goals

As highlighted in this and previous IEQs, fuel subsidies remain a major source of fiscal risk, dent the ability of the flexible exchange rate to absorb shocks, and divert spending away from more efficient uses, including the needed increases in public investment. Although any fuel price increases appear politically unpalatable ahead of elections, there is clearly a strong need for further reforms, while at the same time improving the safety net for the poor and vulnerable. Reform options include those that may not result in an immediate increase in prices, such as implementing a rule-based approach for setting subsidized fuel prices in such a way as to gradually limit the fiscal exposure to higher Rupiah-denominated fuel prices.

along with measures to make further progress in the fight against poverty,

Reallocating spending from subsidies could support a strengthening of Indonesias social assistance programs. While the recent expansion in long-term social assistance programs from the third quarter of 2013 is welcome, social assistance spending (at about 0.5 percent of GDP) remains low by global standards and commitment to the ongoing growth of social assistance, and effective program implementation, will be required to help speed up poverty reduction. For example, poverty in Indonesia fell by 0.6 percentage points in the year to March 2013, to 11.4 percent as measured by the official rate. Moving into 2014, higher prices and slower economic growth add to the poverty reduction challenge. Indeed, the World Bank projects the March 2014 poverty rate to be 11.0-11.1 percent, indicating a continuation of the ongoing slowing of poverty reduction and suggesting that the Governments 2014 target of an 8-10 percent poverty rate will likely be missed.

to address longer-term labor market challenges and support governance capacity at the local level

To make further progress in achieving Indonesias medium-term development objectives, it will be necessary to support ongoing positive structural change in the labor market. This requires steps to enhance productivity and facilitate formal sector employment growth in higher value-added sectors, including by increasing the skills base of the labor force. This edition of the IEQ also considers the insights from recent survey results on another key element for delivering on Indonesias development goals, namely strengthening local governance capacity for effective service delivery.


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A. Economic and fiscal update

Slowly improving global demand, external financing risks remain 1.

The growth performance of Indonesias major trading partners remained mixed through the end of 2013

Economic conditions amongst the worlds largest economies, and Indonesias major trading partners, remain uneven. The Euro Area finally exited from recession in the second quarter of 2013, following six consecutive quarters of contraction, but growth softened again in the third quarter (to 0.4 percent at a seasonally-adjusted annualized rate, qoq saar), suggesting that its path to recovery remains bumpy. Growth also weakened in Japan in the third quarter, to 1.1 percent qoq saar, while, in contrast, US growth firmed to 3.6 percent qoq saar, suggesting that the US economy has continued to gain steam fairly steadily through 2013. Amongst major developing economies, growth in China moved up to 9.3 percent qoq saar, but in Brazil output contracted in Q3 versus Q2, by 0.5 percent (seasonally adjusted), and growth has been relatively subdued in India (at 4.8 percent year-on-year, yoy, in Q3), though recently showing signs of re-accelerating.

but global demand is expected to stage a modest improvement in 2014

Looking ahead to 2014, high income economy growth is expected to remain at or above its recent pace, with the Euro Areas still-fragile recovery expected to continue, and the US economy expected to expand at close to its current rate. Supported by this mild expansion, developing country growth is also expected to increase, with Chinas economy growing by 7.7 percent in 2014, and developing country growth excluding China climbing to above 4 percent in 2014, up from approximately 3.5 percent in 2013. Consequently, the World Bank projects the weighted average growth of Indonesias major trading partners to increase to 3.9 percent in 2014, up 0.5 percentage points from 2013. In the base case, therefore, international demand should increase moderately through 2014, supporting a continued modest expansion in the demand for Indonesias exports.


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and Indonesias major commodity prices may be stabilizing, following over two years of sustained losses

International commodity prices have generally increased in recent months. The weighted US Dollar price index of Indonesias ten most important export commodities, accounting for approximately half of total export revenues, troughed in September and picked up through the end of November, helped by higher coal, natural gas, and palm oil prices (Figure 1). As a result the year-to-November decline was trimmed to 2.5 percent from 7 percent in September. However, the index remained down 22 percent from its February 2011 peak, with the prices of coal (down 40 percent), palm oil (down 37 percent) and copper (down 27 percent) having fallen most precipitously from their 2011 highs. Should it prove sustained, the nascent stabilization in commodity prices would help arrest the decline in Indonesias terms of trade which has driven much of the deterioration in its external balances. However, the base line outlook of only a moderate pick-up in global growth conditions through 2014, coupled with the likelihood of tightening global liquidity conditions and more structural supply-side factors placing downward pressure on prices, does not suggest a major upswing in commodity prices. In addition, as noted in the October 2013 IEQ, Indonesias terms of trade continue to suffer from the fact that global oil prices, impacting the countrys sizable fuel imports, remain relatively elevated compared with non-energy commodity prices.

However, ongoing policy uncertainties cloud the international outlook

While the expected modest increase in global growth in 2014 should be broadly positive for Indonesia by supporting overall export demand, the international outlook continues to be clouded by major policy uncertainties, keeping the risks of more adverse global growth scenarios elevated. In Europe, high unemployment (12 percent for the Euro Area), large output gaps, and continued credit contractions in the periphery generate deflation risks, while reform fatigue may mean that the reforms necessary to boost structural growth prove hard to deliver, complicating the economic recovery. In Asia, the pace and manner in which ambitious structural reform efforts in China and Japan are implemented, and national elections in India, will shape the outlook.

Figure 1: Key commodity export prices show signs of stabilizing at broadly flat levels compared with a year ago (US Dollar commodity price index, 2007 average=100)

Figure 2: Global and emerging market sovereign debt funding costs remain on an up-trend (yields, percent)

Note: Top 10 index is index of USD prices of Indonesias 10 most important export commodities, weighted by share in 2012 exports Source: World Bank

Note: Emerging market and Indonesia USD bond yields as measured by JP Morgan EMBIG index and Indonesia sub-index Source: JP Morgan

and external financing and market conditions pose ongoing challenges

Above all, the global financial market and ultimately real economy impact, and timing, of the gradual phasing out of the US Federal Reserves asset purchase program (so-called tapering) is uncertain, but keeps the risks of international market volatility and more difficult external financing conditions to the fore. US yields remain well up from their levels before tapering came into focus in May, with the US 10-year Treasury yield at 2.9 percent on 11 December up from 1.6 percent in April. Dollar sovereign borrowing costs for emerging markets have increased by approximately 160 basis points in 2013 on average (as measured by the blended yield of the JP Morgan Emerging Market Bond Index). As the US Federal

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Reserve negotiates the normalization of monetary policy, the likelihood of upward pressure on longer-term borrowing costs globally, along with bouts of market volatility as experienced during the tapering dress rehearsal period of May-August, will remain a concern. Emerging markets, including Indonesia, therefore face tighter global liquidity conditions, placing upward pressure on their external funding costs and potentially making it more difficult to rely on net portfolio investment inflows to meet external financing needs.

Despite strong consumption, Indonesias economic growth is slowing 2.

Economic growth in Indonesia continued to moderate in Q3

Tightening external financing conditions, beginning in May, have compounded the gradual transmission of lower commodity prices since 2011, precipitating a number of important economic and policy adjustments in Indonesia, and weighing on growth. The pace of expansion of Indonesias economy has slowed down, a trend which the World Bank expects to continue at least into the early part of 2014. Real GDP in the third quarter was up 5.6 percent yoy, marking the fifth consecutive quarter of weakening growth in year-on-year terms, down from the recent high of 6.4 percent in Q2 2012 (Figure 3). In sequential terms, growth in Q3 slipped to 5.0 percent qoq saar, down from 5.5 percent in the previous two quarters and the recent high of 6.6 percent in Q4 2012. In contrast to real GDP, nominal GDP growth picked up sharply, to 12.1 percent yoy in Q3 from 8.2 percent yoy in Q2, reflecting an increase in the growth of the GDP deflatorthe broadest measure of prices across the economywhich had previously fallen to very low levels. This is line with the sharp rise in consumer prices following the June subsidized fuel price increase (Figure 4), and likely also reflects higher import prices as a result of the Rupiah depreciation.

Figure 3: Real GDP growth is moderating, falling to 5.6 percent yoy and 5.0 qoq saar in Q3 (real GDP growth, percent)

Figure 4: though nominal GDP growth increased sharply in Q3 on the back of rising economy-wide prices (growth yoy, percent)

Source: BPS; World Bank staff calculations Source: BPS; World Bank staff calculations

mainly reflecting weak investment growth

The key driver of the moderation in growth in Q3 was fixed investment, which expanded by a weak 2.6 percent qoq saar to be 4.5 percent higher yoy. Investment growth, while volatile across quarters, has been on a downward trend since its recent peak of 12.5 percent yoy in Q2 2012 (Figure 5). Building investment, which accounts for approximately 85 percent of total nominal fixed investment spending, has remained resilient, in fact expanding at a rapid 9.5 percent pace (qoq saar) in Q3. The slowdown in overall investment has been driven by the smaller but more volatile components of investment spending. Spending on foreign machinery, equipment and transportation goods (together accounting for the bulk of non-building fixed investment) was close to flat in Q3 compared with Q2, leaving them well below their year-ago levels (with foreign machinery and equipment and foreign transportation goods down 0.5 percent and 8.4 percent yoy, respectively).

0

1

2

3

4

5

6

7

8

9

Sep-06 Sep-08 Sep-10 Sep-12

Quarter on Quarter saarYear on year

-10

0

10

20

30

Sep-06 Mar-08 Sep-09 Mar-11 Sep-12

GDP deflator

Nominal GDP

Consumer Price Index


4


which has put downward pressure on imports, while export volumes stayed subdued

Flat or contracting demand for machinery and equipment, in turn, has limited imports. Import volumes contracted sharply in the third quarter, by 3.0 percent from the second quarter in seasonally-adjusted terms. Export volumes were little-changed from the second quarter (declining by 0.8 percent, seasonally adjusted). In combination, net exports therefore added significantly to output growth in the third quarter.

In contrast, consumption growth has stayed strong

Private consumption, which accounts for about 55 percent of total expenditure, continued to increase strongly in Q3, by 6.9 percent qoq saar to be up 5.5 percent yoy, despite the June increase in subsidized fuel prices and the monetary policy tightening, as well as the financial market turbulence and currency depreciation experienced over the quarter. The resilience of household spending reflects in part the positive impact of the Governments IDR 30 trillion compensation package following the fuel price increase (which began to be disbursed during Q3, as discussed further in section B.1, and compares with the estimated rise in consumption over the quarter of IDR 111 trillion). Other reasons likely include lags in the transmission of monetary policy to the real economy, consistent with the still rapid pace of credit expansion recorded through September, delays in the impacts of the asset price movements seen over the quarter (which have increased import and financing costs) on domestic prices, and relatively limited near-term linkages between asset prices and consumer spending (that is, only modest wealth effects).

Figure 5: Investment growth has slowed markedly while consumption growth has remained strong (real GDP and expenditure constituents growth yoy, percent)

Figure 6: with only building investment driving overall positive investment growth (contributions to overall investment growth yoy, percent)


The construction sector remained strong in Q3, and the services sector continues to drive growth

On the production side, reduced growth was broad-based across sectors in Q3, but most concentrated in manufacturing and trade, hotels and restaurants. The construction sector grew by 5.9 percent qoq saar to be up 6.2 percent yoy; a slightly slower pace than in Q2 but broadly consistent with the strong pace of building investment discussed above. Services sector growth remained generally solid, at 6.3 percent qoq saar (up 7.3 percent yoy), but a moderation in the biggest services sub-sectortrade, hotels and restaurantswas visible, with output growth slowing to 2.8 percent qoq saar, leaving Q3 output up 6.0 percent yoy, compared with a 6.5 percent increase yoy in H1 2013. Industrial output growth, excluding mining, slipped to 2.4 percent qoq saar (3.8 percent yoy). Mining output was flat compared with Q2 on a seasonally-adjusted basis, with output 1.6 percent higher yoy, but this masked diverging trends in the two main mining sub-sectors: crude oil and natural gas output remains subdued (down 3.0 percent yoy), while non-oil and gas mining output picked up, increasing by 3.2 percent qoq saar, potentially reflecting a pick-up in production ahead of the raw mineral export ban beginning in January 2014 (see Box 1).

-4

-2

0

2

4

6

8

10

12

14

Sep-10 Jun-11 Mar-12 Dec-12 Sep-13

Private cons. Gov cons.Investment Net ExportsDiscrepancy GDP

-2

0

2

4

6

8

10

12

14

Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13

Building Machinery

Transportation Other

Total


5


High frequency indicators are mixed but are consistent overall with a more moderate pace of domestic demand growth

High frequency economic activity indicators suggest that consumer sentiment remains below the highs seen in the first half of 2013 (i.e. before the June subsidized fuel price increase), though not that sentiment is on a sustained down-trend. BIs survey measure of retail sales picked up to 12.1 percent yoy in November, but its growth rate remains lower than the Q4 2012 highs of around 17 percent yoy. Vehicle sales growth has also slowed relative to the high levels of 2012 and early 2013, while motor cycle sales have been high since Idul Fitri but with declining momentum. On the production side, cement sales over the available 2-month period since Ramadan (i.e. September and October) were up 12.9 yoy, roughly halving from growth of over 21 percent yoy seen early in 2013 (Figure 7). The HSBC Purchasing Managers Index (PMI) for Indonesias manufacturing sector suggests marginally expansionary conditions, standing at 50.3 for November.

Figure 7: High frequency indicators are mixed but are below their previous highs (BI retail sales index, vehicle sales and cement volumes, 3mma yoy, percent)

Source: BPS; World Bank staff calculations

and output growth is projected to slow further

The World Bank expects that Indonesias GDP growth will slow further, to 5.3 percent in 2014 in the base case (Table 2). Domestic demand faces headwinds from tighter financial conditions, as discussed further in Section 5, but also from potentially longer-term constraints due to less supportive commodity prices and terms of trade than in recent years. In particular, private consumption, the mainstay of the Indonesian economy, has so far remained notably resilient, but is likely to come under more strain, denting growth. The investment outlook hinges on building investment, which in the face of tighter credit, reduced investable funds from commodity-related profits, and increased import costs (as discussed in Section 4) is also likely to slow. Election-related spending in 2014 will likely add materially to domestic demand, as campaign-related activity adds to private consumption, but is temporary in nature, and may in part substitute for other spending. Overall, risks to the growth outlook are skewed to the downside, as discussed in Section 7.

-30

-20

-10

0

10

20

30

40

50

Nov-11 May-12 Nov-12 May-13 Nov-13

Motor vehicles

Cement

Retail sales

Motor cycles


6


Table 2: Under the baseline scenario GDP growth of 5.6 percent is projected for 2013 and 5.3 percent for 2014 (percentage change, unless otherwise indicated)

Annual Year to December quarter Revision to Annual 2012 2013 2014 2012 2013 2014 2013 2014 1. Main economic indicators Total consumption expenditure 4.8 5.1 4.8 3.9 4.8 5.2 0.1 -0.2

Private consumption expenditure 5.3 5.1 4.9 5.4 4.4 5.2 0.2 -0.3 Government consumption 1.2 5.0 4.4 -3.3 7.0 5.0 -1.1 -0.1

Gross fixed capital formation 9.8 4.4 4.4 7.3 3.1 5.4 -0.9 -0.5 Exports of goods and services 2.0 4.4 5.4 0.5 3.8 7.0 -1.3 -0.3 Imports of goods and services 6.6 0.5 3.4 6.8 -1.9 4.0 -1.9 -1.2 Gross Domestic Product 6.2 5.6 5.3 6.1 5.1 5.4 0.0 0.0 Agriculture 4.0 3.7 2.7 2.0 5.3 2.6 0.3 0.3 Industry 5.2 4.5 4.2 5.4 3.8 4.4 0.1 0.2 Services 7.7 7.1 6.8 7.6 6.2 6.8 -0.2 -0.2 2. External indicators Balance of payments (USD bn) 0.2 -14.0 -12.8 n/a n/a n/a 1.4 -8.8

Current account bal. (USD bn) -24.4 -30.6 -22.8 n/a n/a n/a -1.4 -0.7 Trade balance (USD bn) -1.7 -9.1 -2.5 n/a n/a n/a -1.2 -1.5

Financial account bal. (USD bn) 25.2 17.1 10.0 n/a n/a n/a 2 -8.1 3. Other economic measures Consumer price index 4.3 7.0 6.1 4.4 8.6 5.1 -0.3 -0.6 Poverty basket Index 6.5 7.8 6.7 5.4 9.7 5.2 0.6 0.4 GDP deflator 4.6 4.4 6.4 2.7 6.6 5.8 1.8 2.2 Nominal GDP 11.0 10.3 12.0 9.0 12.0 11.6 1.9 2.3 4. Economic assumptions Exchange rate (IDR/USD) 9419 10600 11800 9630 11800 11800 200.0 400.0 Indonesian crude price (USD/bl) 113 104 103 108 105 103 -1.9 -2.0 Major trading partner growth 3.4 3.4 3.9 3.1 4.0 4.0 0.0 0.0 Note: Projected trade flows relate to the national accounts. Exchange rate is an assumption based on recent averages. Revisions are relative to projections in the October 2013 IEQ Source: MoF; BPS; BI; CEIC; World Bank projections

Headline inflation has normalized but core inflation is rising 3.

Consumer inflation has been volatile over 2013

Consumer prices have been volatile over 2013, reflecting first the impact of trade restrictions on certain foods (later unwound), and then the impact of the June increase in subsidized fuel prices. While the direct impact of the fuel price increase has now faded and food price disinflation has set in following Idul Fitri, underlying inflation pressures (as measured by core CPI) have increased significantly since May. Going forward, the challenge for monetary policy will be to gauge ongoing risks of higher pass-through from the exchange rate into consumer prices (sometimes called imported inflation), and rising price expectations, broadly offset by the expected continued moderation in domestic demand.

but headline inflation momentum is now subdued as the effects of the fuel subsidy reform and Ramadan have faded

Consumer prices as measured by the headline consumer price index (CPI) surged by 5.5 percent from June to August, largely as a result of the 33 percent average increase in subsidized fuel prices implemented on June 22, but also the seasonal impact of Ramadan, which this year fell in July/August. This abrupt increase in the price level has elevated year-on-year inflation to 8.4 percent in November. However, headline inflation momentum has abated since August, with the headline CPI essentially flat month-to-month over this period, as transportation-related price increases have flattened out and food prices have fallen back significantly from their Ramadan-related increases in the middle of the year (Figure 9).


7


with welcome food price deflation having set in following a volatile 2013 for some key food prices

Domestic food prices in Indonesia have been volatile in 2013, climbing early in the year on the back of trade restrictions which significantly pushed up the prices of items such as onions, chili and garlic. The subsequent unwinding of these measures provided some price relief in the second quarter, before the seasonal impact of Ramadan in July/August brought renewed upward pressure on many food prices (Figure 8). Helped by the seasonal post-Ramadan decline in many food prices, three consecutive months of overall food price deflation in month-on-month terms through November has now lowered raw food price inflation from a peak of 15.1 percent yoy in August, to 12.2 percent in November.

Figure 8: The prices of some key foods are stabilizing after a volatile year (price index, November 2012 average=100)

Source: BPS; World Bank staff calculations

Rice prices have increased fairly modestly, though remaining well above international prices

The domestic price of rice, a key component of the consumption basket of poor households in Indonesia, increased by 5.1 percent yoy in November. This fairly modest increase was due to relatively favorable production. Indonesias rice production in 2013 is estimated officially to have increased by 2.6 percent following the final harvest of the year, to 70.87 million tons (44.6 million tons on a milled basis), mainly reflecting expanded acreage, as yields are estimated to have remained at 2012 highs of 5.1 tons per hectare. The modest rise in domestic rice prices has also contributed to a reduction in the gap between Indonesian and comparable international prices (from Thailand or Vietnam). Indonesian prices were a record 90-110 percent higher (depending on quality) than international prices in June, falling to 5060 percent higher in November. The reduction of the Indonesian-international rice price gap was also driven by an increase in Rupiah-denominated international rice prices (including an 8 percent and 29 percent increase for medium quality rice from Vietnam in US Dollar in Rupiah terms, respectively).

The pick-up in core inflation, however, suggests caution is still needed around inflation risks

Although the lack of upward momentum in headline CPI is an encouraging indication that overall consumer price pressures remain contained, the recent pattern of core inflationwhich excludes volatile items such as food and fuelargues for caution (Figure 10). Core CPI increased by 4.8 percent yoy in November, its highest monthly reading since September 2011, and its recent pace of increase, a 7.7 percent annualized rate from September to November over the previous three months, has been significant.

0

50

100

150

200

250

300

350

400

450

Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13

Garlic

Onions

Beef

Ramadan

Chili

Soybeans

Eggs


8


Figure 9: Seasonal food deflation and fading transport price rises have pushed down headline monthly CPI inflation (composition of monthly increase in headline CPI, percentage points)

Figure 10: but core inflation momentum has increased notably (annualized 3-month/3-month change, percent)


especially in light of cost-push pressures from the weaker Rupiah

One source of upward pressure on core inflation since May has likely been the depreciation of the Rupiah which, while broadly supportive for Indonesias economic adjustment to external constraints, adds to cost-push inflation pressures through the price of imported goods. Given the significant 24 percent nominal depreciation of the currency year-to-date, the rise in core inflation has so far been relatively modest. However, in the absence of a counterfactual, it is important to note that inflation may have been more subdued in the absence of the Rupiah depreciation. It is also likely that the weaker Rupiah will continue to feed into inflation with a lag, as importers may absorb higher import costs for a time in order to preserve market share, but later pass on increases as a result of ongoing margin erosion. Finally, with much of the Rupiahs adjustment to date having occurred only since August, it is too soon to know for sure how Rupiah depreciation will feed through into inflation. As a rule of thumb, however, it is estimated that a 10 percent Rupiah depreciation adds approximately 0.5 percentage points to inflation in a given quarter.

In the base case, headline inflation is expected to remain below its recent peak, but core inflation pressures to remain on the rise through the first half of 2014

In the base case, inflation pressures are expected to remain contained, consistent with the weaker growth outlook, with headline inflation declining gradually through Q2 2014 to approximately 7.5 percent. Headline inflation is then expected to fall sharply as the impact of the June 2013 fuel price change drops out of the base in Q3 2014, following which headline CPI should return to below the ceiling of BIs current target band of 3.5-5.5 percent yoy. Core inflation, however, is expected to be pushed higher in coming months (to approximately 5.5 percent in Q1 2014) by the exchange rate and wage rises, including from the impact of new minimum wage increases for 2014 (including the 11 percent increase agreed for the District of Jakarta). Risks to the base case expectations for inflation are balanced, with the outlook depending on the interplay between Rupiah depreciation, wage-setting for 2014 and temporary factors such as higher election-related spending in Q1 2014, set against the weaker domestic demand growth trend and tighter financial conditions.

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Nov-11 May-12 Nov-12 May-13 Nov-13

Other items

Housing & related

Transport, communication and finance

Food

-5

0

5

10

15

20Headline

Core


9


Indonesias current account deficit remains in focus, despite slowing 4.imports

External balance pressures remain central to the outlook for Indonesias economy

Indonesias current account deficit showed signs of stabilizing in the third quarter, but at USD 8.4 billion remained well above net direct investment of USD 5.1 billion, implying a significant basic balance deficit (of USD 3.3 billion in Q3). This gap highlights Indonesias continuing reliance on potentially volatile portfolio investment inflows, a potential vulnerability that is likely to remain a strong focus for policymakers and investors. In addition, although Indonesias overall external debt burden is low, external debt repayments are significant, adding to the currency and refinancing risks faced by the Government and corporate sector in the context of ongoing international financial market uncertainties. In the base case, the current account balance is expected to narrow through 2014, but the modest likely pace of improvement, and economic costs of import compression, argue for a continued policy focus on improving export performance and supporting foreign direct investment as a source of high quality external financing.

Indonesias current account deficit narrowed to 3.8 percent of GDP in Q3 from 4.4 percent in Q2

In the third quarter of 2013, the current account deficit was USD 8.4 billion, or 3.8 percent of GDP (Figure 11), narrower than the USD 10 billion or 4.4 percent of GDP deficit seen in the second quarter. Early indications for the final quarter of 2013 are that this gradual narrowing of the deficit is set to continue, with the monthly goods trade balance, as measured by BPS, albeit volatile, returning to a small (USD 42 million) surplus in the month of October.

Non-oil and gas export revenues were weak in Q3 but show some signs of having picked up into Q4

The non-oil-and-gas goods trade balance returned to surplus in August after four consecutive months of deficit, and remained positive through October (Figure 12). Non-oil and gas exports slowed through Q3, reflecting in part further weakening in the global prices of major commodity exports in the early part of the quarter, and the dampening impact of Idul Fitri holidays on exports. Within non-oil and gas exports, manufacturing export revenues dropped by 2.8 percent relative to Q3 2012 and non-manufacturing (including all major commodities ex-oil and gas) export revenues were down by 8.1 percent relative to Q3 2012. Early indications of export performance in the fourth quarter are encouraging, with exports across the region firming, and Indonesias non-oil and gas export revenues rising by 2.5 percent yoy in October, likely helped by improving demand from key trading partners such as the US and China. As discussed in Section 2, export volumes also appear to have broadly held up through the latest available, third quarter data, being up 5.3 percent yoy, showing the depressing effect on export revenues of low prices and pointing to the possible rebound of export revenues in coming quarters should commodity prices indeed have stabilized and external demand continue to increase modestly. A significant risk to exports, however, is the mooted ban on raw mineral exports, discussed in Box 1.

while the oil and gas trade deficit appears largely unaffected by the increase in subsidized fuel prices

Most of the weakening in Indonesias overall current account balance since late 2011 has been due to the collapse of the non-oil and gas trade surplus, driven mainly by declining commodity export prices. However, Indonesias monthly oil and gas trade balance also remains a major drag on the overall trade balance, and has moved into deficit since August 2012. The oil and gas trade deficit stood at USD 2.4 billion in Q2 and widened to USD 3.9 billion in Q3, amplified by higher holiday season-related fuel demand but also suggesting that oil import demand has been relatively insensitive to the sharp increase in subsidized fuel prices implemented in June. Subsequent monthly data, for October, does show a significant drop in oil-and-gas importswith the oil and gas deficit shrinking by 50 percent mom to USD 750 millionbut given the volatility of the monthly data this is insufficient to gauge whether significant fuel import relief is now filtering through.


10


Figure 11: The current account deficit stabilized at USD 8.4 billion in Q3 (account balances, USD billion)

Figure 12: helped by the non-oil-and-gas trade balance returning to surplus since August (account balances, USD billion)

Source: CEIC; World Bank staff calculations Note: O&G: oil and gas Source: CEIC; World Bank staff calculations

Import compression is now clearly visible, providing relief for the trade and overall current account balance

As real growth moderates and the Rupiah has depreciated, slowing imports are supporting the trade balance and the gradual narrowing in the overall current account. Capital goods in October were 20 percent lower yoy (and down 16 percent on a 3-month moving average basis, yoy), consistent with subdued machinery and equipment spending as outlined in Section 2. Imports of intermediate goods, excluding oil and gas, were down 4.1 percent yoy in October, on a 3-month moving average basis. Consumer goods imports account for only a small share of imports (7 percent of total import costs, over the 12 months through October) but have been flat since August at similar levels to one year ago. Oil and gas imports are the only major import category to have remained stubbornly high during Q3 but, as noted above, even these recorded a significant slowdown in October (Figure 13).

Figure 13: The weakness in overall imports has been led by a contraction in capital goods (growth of 3-month moving average of import components yoy, percent)

Figure 14: Manufacturing and construction together absorb almost 70 percent of Indonesias imports (sectoral allocation of nominal imports in real terms, percent)

Note: Intermediate goods excludes oil and gas Source: BPS; World Bank staff calculations

Source: World Input-Output database 2011; World Bank staff calculations

and may have further to run, but with real economic costs

The economic sectors which make the heaviest use of imports are manufacturing and construction (Figure 14), together absorbing close to 70 percent of total imports. Three quarters of theseor half of total importsare intermediate products from foreign

-15

-10

-5

0

5

10

15

Sep-09 Sep-10 Sep-11 Sep-12 Sep-13

Current transfers Income balanceServices trade balance Goods trade balanceCurrent account balance

-4

-2

0

2

4

-20

-10

0

10

20

Sep-09 Sep-10 Sep-11 Sep-12 Sep-13

Non-O&G importsO&G importsNon-O&G exportsO&G exportsNon-O&G trade balance (RHS)O&G trade balance (RHS)

-40

-20

0

20

40

60

80

Oct-11 Apr-12 Oct-12 Apr-13 Oct-13

Consumer goods

Capital goods

Oil and gasIntermediate goods

Total imports

0 10 20 30 40 50

Utilities

Mining & quarrying

Financial & bus. Services

Agriculture

Trade, hotel & restaurant

Transport & com.

Services

Construction

Manufacturing industries


11


manufacturers. In addition, about 50 percent of manufactured imports into the most import-heavy sectors comprises of specific inputs to production, notably chemical and metal products, and equipment. Consequently, the expected ongoing moderation in manufacturing and construction growth in 2014 will likely assist in continuing to lower the import bill (Figure 14), but may also have implications for employment and income generation in those sectors. In addition, as described in the March 2013 IEQ, there is a sizable component of imported inputs used in the production of Indonesias non-commodity exports. Higher costs of imported inputs to productiondue either to ongoing Rupiah depreciation or other policies aimed at import suppressiontherefore may also potentially weigh on export competitiveness, offsetting some of the benefits from the real exchange rate depreciation.

As the trade balance adjustment plays out, the focus on Indonesias external financing vulnerabilities is likely to remain

Overall, indications are that Indonesias trade balances are shifting in such a way as to stabilize and begin to narrow the overall current account deficit. As mentioned above, quarterly goods and services export volumes, as measured by the national accounts, have held up, and goods export revenues as measured by the monthly BPS trade data increased in year-on-year terms in October for the first time since March 2012 (albeit by a modest 2.6 percent). Import compression is visible, as described above, and even the oil and gas trade deficit which has opened up since August 2012 shows some signs of narrowing. While positive for returning Indonesias overall external balances to a sustainable position, however, import compression comes with costs, and the pace of improvement so far has been gradual, keeping external financing vulnerabilities very much in focus.

Financial account inflows declined in the third quarter as net portfolio inflows weakened and currency and deposit flows turned negative

Turning to the financial account side of the balance of payments, Indonesia's capital and financial account posted a surplus of USD 4.9 billion in Q3, narrowing from USD 8.4 billion in Q2, reflecting a weakening in portfolio investment inflows and other investment outflows, despite strengthening net direct investment inflows. Net portfolio inflows eased to USD 1.8 billion (from USD 3.4 billion in Q2), driven by weak net inflows into both debt and equity securities, as also experienced by other major emerging market economies, and partly reflecting uncertainty during the quarter regarding the timing and pace of tapering by the US Federal Reserve. Weaker offshore bond issuance in Q3 also played a role. Other investment recorded a deficit of USD 2.1 billion largely due to currency and deposit outflows. This reversed the surplus seen in Q2, which was due to a combination of seasonal USD currency inflows aimed at servicing seasonal corporate US Dollar demand.

making Indonesia more dependent on supporting FDI inflows

Net direct investment recorded a surplus of USD 5.1 billion (from USD 3.8 billion), reflecting strong inbound direct investment inflows of USD 5.4 billion together with a weakening in outward direct investment abroad to USD 0.3 billion. FDI into debt instruments in Q3 2013 was at its highest level since Q4 2011 in Q3, USD 1.9 billion, up from USD 453 million in Q2. FDI into equity on the other hand dropped by 17 percent from Q2, at USD 3.5 billion. Overall, direct investment inflows appear to be holding up in the face of the weakness in global commodity prices in recent quarters and heightened regulatory uncertainty in key sectors for inbound investment, especially mining. These inflows, however, can be lumpy and are based on long-term decisions which are affected by the policy environment, which is subject to risks as described in Section 7.

The current account deficit is projected to narrow to 2.6 percent of GDP in 2014

The current account deficit is projected to reach to 3.5 percent of GDP or USD 30.6 billion in 2013 as a whole, on the back of a narrowing in the current account deficit for the fourth quarter to approximately USD 6.4 billion (or 3.2 percent of GDP). In 2014, the current account deficit is projected to persist, although narrowing to USD 22.8 bn (2.6 percent of GDP) supported by subdued import growth and a mild pick up in export demand (Table 3). This baseline view, however, remains contingent on external financing conditions being sufficiently supportive, in light of the fact that Indonesia will likely continue to run a basic balance of payments deficit through 2014, increasing its reliance on potentially volatile portfolio investment flows. In addition, a specific additional risk to the trade balance is the impact of the ban on raw mineral exports, scheduled to come into effect in January 2014 (Box 1).


12


Figure 15: Weaker portfolio investment led to a lower capital and financial account surplus in Q3 relative to Q2 (account balances, USD billion)

Table 3: The persistence of a current account deficit is likely to keep the need to support FDI in focus (USD billion)

2011 2012 2013 2014 Overall Balance of Payments 11.9 0.2 -14.0 -12.8

As percent of GDP 1.4 0.0 -1.6 -1.5 Current Account 1.7 -24.4 -30.6 -22.8

As percent of GDP 0.2 -2.8 -3.5 -2.6 Trade 24.2 -1.7 -9.1 -2.5 Income -26.7 -26.8 -25.8 -24.6 Transfers 4.2 4.1 4.2 4.3

Capital & Financial Accounts 13.6 25.2 17.1 10.0

As percent of GDP 1.6 2.9 2.0 1.2 Direct Inv. 11.5 14.0 16.5 13.2 Portfolio Inv. 3.8 9.2 9.9 3.1 Other Inv. -1.8 1.9 -9.4 -6.3

Memo: Basic Balance 13.2 -10.4 -14.1 -9.6

As percent of GDP 1.6 -1.2 -1.6 -1.1 Source: CEIC; World Bank staff calculations Note: Basic balance = current account balance + net FDI

Source: CEIC; World Bank staff calculations

-16

-12

-8

-4

0

4

8

12

16

Sep-10 Sep-11 Sep-12 Sep-13

Overall balance

Basic balance

Net direct investment

Net other capital

Current account

Net portfolio

The current account deficit, combined with sizeable external debt amortizations, contribute to Indonesias high external financing needs

Table 4: External debt repayments in Q4 2013 have been high, likely adding to Rupiah pressures (projected gross external debt repayments, USD million)

Oct - Dec 2013 Jan-Sep 2014 Government and Central Bank 2,131 10,087 Private 18,894 15,617

Bank 3,720 3,074 Non-bank 15,174 12,543 Non-bank financial institutions 1,738 2,199 Non-financial corporations 13,436 10,345

Total 21,025 25,704 Note: Based on external debt position as of September 2013; debt repayments exclude domestic securities owned by non-residents, currency and deposits, and other liabilities Source: Bank Indonesia

While the current account deficit is projected to continue narrowing gradually, Indonesias gross external financing needs remain high. Significant external debt amortizations add to a still sizeable level of the current account deficit. For example, gross external debt repayments will total USD 21.0 billion in Q4 2013, and USD 25.7 billion over the first three quarters of 2014, according to Bank Indonesia (Table 4). Projected total external debt amortizations on this basis, of USD 41.2 billion over 2013, compare with the World Banks projection for the 2013 current account deficit of USD 31 billion.


13


Box 1: The potential near-term impact of the proposed ban on unprocessed mineral exports on Indonesias trade balance

As 2014 approaches, attention has turned to the potential impact of the proposed ban on unprocessed exports, which is set to come into effect from January 2014. The 2009 Mining Law (UU 4/2009) requires all mining business permit (IUP) and Contract of Work (CoW) holders to add value to mining products through domestic refining and processing with a five year compliance horizon. Initially set to come into force in May 2012, the proposed ban was delayed until January 2014, where based upon current regulations, IUP and CoW holders will no longer be permitted to export mineral ores or refined products of copper, nickel, tin, bauxite and iron ore, among others, that are below the minimum mineral content all requiring smelting capacity.* At the time of writing, the implementation details of the proposed ban are still under discussion. In part this reflects concerns about the potential near-term impact on Indonesias mineral exports, at a time when Indonesia already faces significant external financing pressures. Commodities account for the bulk of Indonesias exports, comprising roughly two-thirds of merchandise exports by value. Exports of processed and unprocessed minerals in 2012 alone totaled USD 10.4 billion, around 5 percent of total exports. The overall share of processed exports in mineral exports has increased steadily, from 40 percent in 2001 to 52 percent in 2012. In broad terms, there are three direct trade channels through which the export ore ban can have an impact on Indonesias trade balance. The first is a negative impact, via lower exports of unprocessed minerals. The second effect on exports (positive) would occur if there are increased volumes of exports of processed minerals. The third effect, through imports of capital and intermediate goods to build and operate smelters, would have a negative impact on the trade balance. Estimating these effects requires a range of assumptions, from the future external demand for processed and unprocessed minerals through to the share of imports in the operational and capital costs of smelters and, crucially, on the timing and scale of future investments in smelting capacity. As such, any estimates are subject to considerable uncertainty. A large number of smelter plans have been proposed, yet it is possible that not all the proposals that have been announced will be built. Further, of those likely to be economically feasible, significant uncertainty persists regarding whether proposed smelters will be operational by early 2014, especially given the long lead times required to construct smelters before commencing operations. Noting this uncertainty, two potential scenarios may be considered, relative to a baseline where no export ban is enforced, to simulate the potential impact of enforcing the ban on Indonesias trade balance, reflecting differences in the pace with which new proposed smelting capacity comes on-line. In the first scenario all the proposed additional smelters that are considered realistic by a recent Support for Economic Analysis Development in Indonesia (SEADI) study on this topic are built on schedule these smelters are due to become operational in 2014 and 2015. In the second scenario none of the new proposed smelters becomes operational within the timelines set by the law and the export ban is enforced. In the first scenario, where feasible smelters come online as anticipated by SEADI, the impact of the increase in processed mineral exports on the trade balance is more than outweighed by the fall in unprocessed mineral exports, at least in 2014. Further, capital imports to build the smelters would be expected to provide a further significant drag on the trade balance. In 2014 the ban is projected to add an additional USD 6 billion to the trade deficit. However, from 2015, the ban would result in a relatively neutral impact on the trade balance, relative to the baseline, as capital imports resulting from smelter construction start to tail off and gains from higher value processed exports begin to offset the loss unprocessed mineral exports arising from the ban. In the second scenario, where no new smelting capacity comes online, the fall in unprocessed mineral exports weighs heavily on the trade balance, without any corresponding increase in processed mineral exports. The nominal value of lost export earnings increases steadily each year from around USD 5 billion in 2014 to almost USD 8 billion in 2017, reflecting foregone increases in unprocessed mineral exports over this period. This simulation exercise demonstrates the potential significant downside risks to Indonesias trade balance from the bans enforcement, particularly should new domestic smelting capacity be subject to significant delays, resulting in insufficient capacity to process raw minerals onshore, with flow on impacts to mineral exports. Even in the comparatively more optimist scenario (i.e. Scenario 1), where all smelters evaluated by SEADI as being economically feasible come online, the ban would still result in a significant, negative shock to Indonesias trade balance of around USD 6 billion in 2014. Such a shock would add around 0.6 percentage points of GDP to Indonesias current account deficit in 2014 moving the projected current account deficit from 2.6 percent to 3.2 percent of GDP, all other things being equal. This would lead to increased external financing needs at a time when global financing conditions become less favorable. In addition, to the extent that investors view enforcement of the ban as a further negative signal of the quality of the domestic policy environment, this could affect portfolio and FDI capital flows (offsetting any FDI inflows associated with any new smelting projects). Relatedly, it is important to note that the above simulations do not cover the longer-term, potentially distortionary, implications of the ban on economic production structures nor cover a detailed assessment of the bans underlying economic policy objectives or of its likely effectiveness in achieving these objectives. *MEMR regulation 7/2012 required COW and IUP holders to formulate smelting plans, define minimum standards for domestic processing and refining, and imposed a ban on the export of raw mineral ores within three months of the regulation (by May 2012). Partly due to lack of capacity, the ban was subsequently pushed back by MEMR 11/2012 to January 2014. In the interim period from May 2012 to January 2014, COW holders have been permitted to continue to export unprocessed minerals without additional restrictions. IUP holders have been permitted to continue exporting unprocessed minerals provided they pay a 20 percent export tax and are able to renew monthly export permits. Note: The list of proposed new smelters used in this analysis is drawn from the report The Economic Effects of Indonesias Mineral-Processing Requirements for Export, USAID, 2013, under the SEADI project for the Indonesian Ministry of Trade


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Credit conditions are expected to tighten further moving into 2014 5.

The Rupiah has depreciated recently, with significant gross external funding needs in Q4 a likely factor

Indonesias sizeable external debt servicing and financing needs, and the resultant increased foreign currency demand, are likely an important factor behind the renewed weakening of the Rupiah since October. After strengthening to IDR 11,020 per USD in late October, the Rupiah spot rate has subsequently weakened to IDR 12,000 on 11 December, leaving the Rupiah down 24 percent against the US dollar so far this year. The Rupiah has now depreciated by almost 18 percent on a nominal trade-weighted basis through 12 December 2013, and by 8 percent in real effective terms through October.

but measures of currency market liquidity conditions have improved on the levels seen in Q3

Significantly, however, the recent renewed depreciation has not coincided with a pronounced tightening in currency market conditions through November, as measured by average turnover in the onshore spot market. This follows a number of measures taken by Bank Indonesia to improve onshore market liquidity, and facilitate adjustment in the Rupiah exchange rate towards its equilibrium level. These measures have included relaxing US Dollar purchasing requirements for exporters, extending the maturity of the BI US Dollar term deposit facility to up to 12 months, as well as holding regular US Dollar swap auctions to facilitate hedging of currency risks. Daily turnover on the onshore spot FX market has averaged around USD 500-600 million thro

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